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SRP Feature

Morrison & Foerster partner Anna Pinedo offers advice to the advisers on suitability, education and written policies and procedures

Protection in the firing line

Structured products, especially those targeted at retail investors, have come under increasing scrutiny lately on both sides of the Atlantic. Articles in the popular press continue to raise concerns that investors chasing yield seek these products out without fully understanding the credit risk, liquidity risk and fees associated with them. Other articles take a broad brush, impressionistic approach to ‘structured’ products, lumping all products that involve some financial engineering into the same category. Others go even further, and speculate that the structuring is unneces-

sary and intrinsically malevolent.

Fear-mongering and populist simplicity aside, market-linked investments, or debt securities with cash flow characteristics that depend on the performance of one or more reference assets, offer distinct benefits that cannot be obtained from other investments. These products are designed to meet certain risk/reward needs of investors and for this reason have found a market.

Consistent with their objective of protect-ing investors, regulators will seek to reduce

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complexity for retail investors and seek greater transparency and clarity in product disclosures. In light of current economic uncertainty and the losses borne by investors in complex structured credit products, concerns are likely to continue to be raised as to whether market-linked products are too complex for retail investors.

Finally, each time new issues arise with respect to a ‘structured’ product, like the recent examination of ETFs, we will see a rise in non-specific concerns regarding all products viewed as complex. Many of these discussions are likely to gloss over the distinctions between complexity and riskiness and are likely to fail to distinguish among different types of retail investors with differing levels of sophistication. Distributors of structured products should take care to review their practices in respect of a number of areas, including those highlighted below.

New product approval process: the firm should have a new product approval process to vet each new structured product or each significant change to an existing product that would raise new issues.

Policies and procedures related to structured products: the firm should adopt detailed policies and procedures that address the distinct issues posed by structured products sales. The procedures

should be reviewed regularly to ensure that they comply with regulatory guidance.

Know your customer and suitability: the policies and procedures should address know-your-customer policies, as well as provide guidance to personnel regarding discharging their suitability obligation. The know-your-customer and suitability rules were recently amended and these amend-ments require distributors to review their processes.

Monitoring concentrations: policies should provide for an approach to monitor concentration of structured products as well as single issuer exposure in client accounts.

“Regulators will seek to re-duce complexity for retail investors and seek greater transparency and clarity in product disclosures. Con-cerns are likely to continue to be raised as to whether market-linked products are too complex for retail”

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Internal education: the firm should adopt internal education requirements designed to ensure that all personnel involved in structured product sales understand the products and there should be close super-vision of sales. Distributors should conduct the diligence necessary to permit them to understand product features. The nature of the diligence will vary by product, but should take into account distinct product features and should include an understand-ing of the liquidity of the product, the creditworthiness of the issuer, the principal, return and/or interest rate and the tax consequences.

Disclosures: distributors generally will rely on disclosures provided by the issuer and the underwriter of the products. However, it is essential that disclosures present a fair and balanced picture of the risks and benefits of the product. In a series of Notices to Members and other communica-tions, Finra and most recently Finra and the SEC, have provided guidance on disclo-sures related to structured products.

Distributors must focus on both materials used only for internal purposes and on materials used with investors. Internal materials also must be fair and balanced.

Type of product: is it a bank product, like a certificate of deposit? Take special care to be clear about FDIC insurance. Or, is it a bank note or a registered product? Depending on the product, there may be restrictions related to the potential inves-tors. Certain products may only be offered to accredited investors, or may be subject to minimum denomination requirements. Certain products may not be appropriate for Erisa accounts.

Product names: distributors should ensure that product names are not confusing or misleading to investors. Both Finra and the SEC have expressed concerns regarding the use of the term ‘principal protection’ without providing accompanying promi-nent disclosure concerning issuer credit risk.

Credit risk: all disclosure and marketing documents should emphasise that struc-tured products are subject to issuer credit risk. In light of the challenges facing financial institutions, market participants should monitor changes in an issuer’s creditworthiness. Distributors must have an approach in place for notifying potential investors of changes in issuer credit ratings, or of any emerging risks affecting an issuer.

“Distributors must also fo-cus on materials used only for internal purposes. In-ternal materials also must be fair and balanced”

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Risk disclosures: Special attention should be paid to clearly highlighting: risks, including the lack of a liquid secondary market; risks specific to particular payout structures; the special tax features of a product; that products generally should be thought of as buy and hold; actual or potential conflicts of interest.

Fees: investors should understand the fees associated with the product.

Compliance with MSDAs: Distributors should be attentive to the terms and conditions of their MSDAs (master selected dealer/distributor agreement).

Advertising: generally, MSDAs will limit a distributor’s ability to create marketing materials and will require that the distribu-tor use only those materials that have been prepared by the issuer and/or the underwriter and approved for use in connection with product offerings. Any advertising must be approved for use and also must meet Finra requirements regarding content, pre-approval and record keeping.

Prospectus delivery: Distributors should ensure that prior to the time of sale, inves-tors have access to the offering documents relevant to an issue, including any prelimi-nary pricing supplement, free-writing prospectus, term sheet, or other disclosures.

Product-specific issues: Regulators have raised additional concerns about certain types of products, and distributors should ensure that they address regulatory guid-ance regarding these products.

Reverse convertibles: In 2010, Finra issued Regulatory Notice 10-09 regarding reverse convertible securities, which focused on sales and marketing communications relating to reverse convertibles.

The notice recommended members ensure investors understand that reverse converti-bles do not provide for principal protection and as a result investors may experience losses on their investments. The notice emphasised that investors should under-

“The discourse relating to structured products regu-lation does not appear to be informed by the dif-ferences among products and investors. There is considerable risk that the baby will be thrown out with the bath water”

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stand the product, the payout structure, that the product is a buy-and-hold product and has a limited secondary market.

To the extent that a firm publishes its own research regarding the reference asset, the representative should disclose the content of the research and how (and whether) the research is relevant to a purchase recom-mendation. Members should not suggest that reverse convertibles are ordinary debt securities and must not present annualised yield or coupon information in a mislead-ing manner. Finra enforcement actions relating to reverse convertibles have cited member firms for unsuitable sales, inad-equate supervision of structured product sales and failure to monitor accounts for concentrated positions in reverse convertibles.

Commodity-linked products: Finra published Regulatory Notice 10-51 reminding firms of their sales practice obligations for com-modity futures-linked securities. The notice highlighted certain risks that may result from the methodologies used in connec-tion with commodity futures-linked securities, including possible deviation between the performance of the commod-ity futures-linked security and the perfor-mance of the referenced commodity. The deviation between the performance of the commodity futures-linked security and the performance of the referenced com-modity’s spot price can produce unex-

pected results for investors who are not familiar with futures markets, or who mistakenly believe that commodity futures-linked securities are designed to track commodity spot prices.

The notice advised that registered repre-sentatives and potential investors should discuss, among other things, the commod-ity, basket of commodities or commodities index that a given product tracks; the product’s goals, strategy and structure; that commodities prices, and the performance of commodity futures-linked securities, can be volatile; that the use of futures contracts can affect the performance of the product as compared with the performance of the underlying commodity or index; the product’s methodology, including its strategy, if any, for managing roll yield and other factors that may affect performance; and the product’s tax implications.

Structured products are popular precisely because they can address the needs of issuers and investors. The current discourse relating to regulation of structured prod-ucts does not appear to be informed by an understanding of the differences among products and the types of investors inclined to be interested in owning them. There is considerable risk that the baby will be thrown out with the bath water. SRP

Anna Pinedo is a partner at Morrison & Foerster in New York.